Ductal budding in the developing prostate is a testosterone-dependent event that involves signaling between the urogenital sinus epithelium (UGE) and urogenital sinus mesenchyme (UGM). We show here that ductal bud formation is associated with focused expression of Sonic hedgehog (Shh) in the epithelium of nascent prostate buds and in the growing tips of elongating prostate ducts. This pattern of localized Shh expression occurs in response to testosterone stimulation. The gene for the Shh receptor, Ptc1, is expressed in the UGM, as are the members of the Gli gene family of transcriptional regulators (Gli1, Gli2, and Gli3). Expression of Ptc1, Gli1, and Gli2 is localized primarily to mesenchyme surrounding prostate buds, whereas Gli3 is expressed diffusely throughout the UGM. A strong dependence of Gli1 (and Ptc1) expression on Shh signaling is demonstrated by induction of expression in both the intact urogenital sinus and the isolated UGM by exogenous SHH peptide. A similar dependence of Gli2 and Gli3 expression on Shh is not observed. Nonetheless, the chemical inhibitor of Shh signaling, cyclopamine, produced a graded inhibition of Gli gene expression (Gli1>Gli2>Gli3) in urogenital sinus explants that was paralleled by a severe inhibition of ductal budding.